The IBD Follow Through Day study seems to be generating a lot of interest, and I promise I will get back to it shortly. The market looks to be setting up for some interesting trading tomorrow morning, though – so I thought I’d focus on more pressing issues.

NYSE down volume swamped up volume by over 9:1 today. That kind of breadth is somewhat unusual and can be a sign of panic. Lowry’s was the first group I’m aware of to do extensive study on “90% days” and they have some excellent material on them.

Intel disappointed after the close and has added fuel to the fire.. As I write this around midnight Dow futures are down 100 points, S&P 500 futures are down 12 points and Nasdaq futures are down a whopping 32 points. Asian markets are also taking it on the chin.

Let’s take a look at history to see how the next few days may be setting up. Going back to 1970, there were one hundred and thrity-two 90% downside days identified by my database. When viewing 90% down days in isolation, this is how the next week looked:

As you can see – by itself a 90% down volume day is not a clear sign of a washout. There is more downside to come more often than not.

The next table looks back to early 1993 – the inception of the SPY. Since then there have been thirty-six 90% down volume days on the NYSE. Of those 36, only 5 times has the SPY gapped lower the next morning by more than 0.25%. With a gap lower looking likely, I thought it might be worth taking a look at those occurrences:

The 90% downside day on its own won’t necessarily wash out the market, but when combined with gap down open it typically has served to mark at least a short-term panic low. Although the sample size for this study is smaller than I typically like, should the gap down occur, the consistent and sizable gains in the study above indicate that traders should be aware of a potentially large intraday reversal.

The market put in a nice rally today as all three major indices rose between 1% and 1.6%, but volume was lower eliminating any chance of an IBD Follow Through Day. I’ll get back to my series on IBD Follow Through Days shortly, but tonight I think it’s more important to follow up on my reversal bar study .

One very important element of trading quantifiable edges is trade management. Just because your risk/reward is good going in to a trade doesn’t mean you can just “set it and forget it”. It’s not a Ronco. By continually monitoring trades and following up on studies you can make sure the edges remain with you.

Since the reversal day on Wednesday the 9th the S&P 500 has pulled back and closed below its reversal day close, and then rebounded higher. This is typical of the type of action we observed in our sample set. All of the 16 winning trades discussed with a 14-day holding period pulled back at least 0.5% below the reversal day close before launching higher. So now that we know we are on the right track, it is important to consider what might derail us.

One observation I can make about the winning trades is that it was very rare to see the low of the 1st pullback violated. In fact the only “winning” trade to close below the low of its first pullback was the August 6, 2007 reversal bar. The first pullback off of that reversal was violated on August 14th and the market dropped an additional 4% over the next day and a half before hammering out a panic bottom. While that one was labeled a winner, it would not have been easy to sit through. The only other times the low of the 1st pullback were violated were on an intraday basis. On 12/11/91 the S&P dipped 0.17% below the pullback low before finishing higher. On 11/13/97 there was a 0.34% intraday dip that reversed and also closed higher.

In looking at the 8 losing trades with 14-day holding periods they all saw their 1st pullback eventually fail. More interesting is how they failed. Six of eight of them saw their rebound off the pullback last 2 days or less. In other words – failures happened fast.

This data indicates to me that the low of the 1st pullback can act as an important level. Traders could consider that level to be a reasonable area to place a stop. The winning trades have typically made higher lows from the outset and the losers have failed their 1st pullbacks quickly. Should the S&P 500 close below 1395 or drop much below it on an intraday basis, the setup will cease to be providing a quantifiable edge. When you no longer have a quantifiable edge you no longer have a reason to be in the trade.

The ability to manage and continually re-evaluate the trade as it unfolds is what ensures quantifiable edges remain quantifiable edges. It’s what allows traders to receive better odds than gamblers. The original expected value (gamblers odds) based on the reversal bar study was about a 2.1% return for the 14-bar holding period. (4% * 16/24) + (-1.7% * 8/24) = 2.1%. Even if moving the stop up to around the 1395 level costs us one of the 16 winners, the expected value is still increased to (4% * 15/24) + (-1% * 9/24) = 2.3%. Traders that took the trade on the pullback as suggested should have a substantially better expected value than this since their entry point would be below the 1409 close on 1/9/08. Throw in the fact that the worst-case-scenario for the trade is now only a 1% loss and the trade now looks incredibly favorable. Conservative traders could also take partial profits at this point to ensure they break even / make a small amount / lose only a small amount, on the trade even if they do get stopped out. I’ll talk more about expected value and trade management in future posts since I feel they’re important concepts that traders should make themselves familiar with.

In my last entry I provided a quick overview of IBD Follow Through Days and posed a number of quantitative questions I intend to tackle. This will be the first installment in the series.

Since the market may be on the verge of providing investors with an IBD Follow Though Day I thought it best to tackle the most important question first. Are IBD Follow Through Days predictive of a new bull rally? If so what is the success rate? According to Investors Business Daily, Follow Through Days carry a success rate of between 70%-80%. To test this we need to first define some terms and make some assumptions:

1) What determines a “significant decline”? Declines can be determined many ways. Some may say it would require a series of lowers lows and lower highs. Others might say a certain amount of time should be involved. Others would simply look at a percentage drop to determine significance. I’m going to keep it simple and just look at percent drops. What percent is most appropriate is also arguable. For today’s test I chose 8%. In future studies I will look at multiple levels, so don’t worry if you don’t like my choice. There are two primary and subjective reasons I chose 8%. First, I wanted a number that wasn’t too small that I was testing every minor correction. A 5% drop could just be a few bad days so that seemed too small. Second, I didn’t want a number too large that IBD followers would tell me about all the great rallies my study missed. Since there weren’t any 10% declines in the S&P 500 from March 2003 through 2006, and Investors Business Daily published several Follow Through Day calls over that period of time, 10% seemed too large. I picked somewhere in the middle – 8%.

3) For the test I used the S&P 500 as the “tradeable index”. Determination of success or failure was based on the movement in the S&P 500. I did this because of the three major indices (Dow 30, Nasdaq, and S&P 500), the S&P was the broadest and generally considered the most representative of the overall market. What should be noted, though, is that I allowed a Follow Through Day to be triggered by any of the three above listed major indices, as per William O’Neil’s definition.

4) Success and failure were the most difficult things to define. Here I wanted to be as liberal as possible to give Investors Business Daily the benefit of the doubt. IBD stated that failure could be defined by either “multiple signs of distribution – significant down days in higher volume” or “if one of the major indices undercuts its recent lows”. I was less stringent and said that the S&P 500 specifically would have to CLOSE below the INTRADAY low of the bottom prior to the Follow Through Day. (This decision incidentally made the 08/06/2002 Follow Through Day a success whereas most people would have labeled it a failure – and some the October 2002 bottom a failure.) Until that happened, it still had a chance to succeed. IBD has never offered a clear definition of success, so here I was on my own. I first decided that if you were going to use the Follow Through Day to make money then there should be a good portion of the move remaining. Therefore the target for success was set at twice the distance from the close of the Follow Through Day to the low of the potential bottom day. As hard as bottoms are to pick, I believe tops are even more difficult, so if you lose a third of the move off the bottom, you may also lose a third off the top. Therefore I wanted the meat of the move in the middle (potential reward) to be at least as much as the initial thrust (potential risk). There were a few instances where the market actually made new highs without fulfilling this requirement – so I made things even easier. I said that any new 200-day high would also signal a “successful” Follow Through Day. This benefited several Follow Though Days. Instances that went from “failure” to “success” include the 08/11/1986 Follow Through Day and the 10/19/1989 Follow Through Day.

I ran the tests back to December of 1971. Since the Nasdaq began trading in 1971 and I wanted to include that as a possible trigger, it made 1971 a reasonable starting year. I needed about 200 bars of data to run some of the calculations and that is why the test only goes back to December of that year. While Investors Business Daily’s research undoubtedly goes back further, 37 years of data is plenty for me. Success or failure prior to that doesn’t concern me greatly.

The ResultsI was unable to duplicate IBD’s success rate of 70%-80% even though I made the definitions of “success” and “failure” as liberal as I could.

Using a 1% upmove as the minimum thrust for a Follow Through Day, since December 1971 through January 11, 2008, 35 of 64 possible Follow Through Days were successful for a success rate of 54.7%.

Changing the minimum thrust from1% to1.7% as IBD has done in recent years resulted in 29 of 52 possible Follow Through Days being labeled “successful”. This equals a 55.7% success rate.

Rigging the definition of success to provide the IBD Follow Through Days the benefit of the doubt still didn’t allow me to approach their claims of 70%-80%. In fact the Follow Through Days would have been 50% or less accurate without my beneficial tweaks.

So back to the original question: Are IBD Follow Through Days predictive of a new bull rally? Well, somewhat. A coin flip is not exactly the kind of quantifiable edge I look for unless rewards are substantially higher than risks – which I will address in another post.

Are they as good as advertised? Not any way that I was able to find. Perhaps they’re running their tests differently than I. Unlike them though, I’m willing to back up my claims with some hard evidence (link to trades table).

In the coming days I’ll be answering many more of the questions I posed last night about Follow Through Days. By the time I reach the end of this series you should hopefully have a solid handle on what kind of quantifiable edge they really provide.

The S&P 500 currently stands about 11% below its October 11th highs. The rally attempt that began near the end of November officially failed last week as the November lows were undercut. Growth-oriented traders everywhere are now eagerly awaiting the next Investors Business Daily Follow Through Day so that they may more aggressively put their capital to work. The IBD Follow Through Day is a technical tool to help investors time market bottoms. My first introduction to the Follow Through Day was in William O’Neil’s book How To Make Money In Stocks. The Follow Through Day is both widely followed and widely accepted as an early signal of a market bottom – but does is really provide investors with a quantitative edge?

While their descriptions are sometimes inconsistent the basic concept and claims of the Follow Though Day may be summed up as follows:

1) After a significant market decline, rather than trying to pick a bottom, investors should wait for a signal from the major averages to let them know the market is likely to begin a new uptrend. This signal is the Follow Through Day.2) A Follow Through Day is a day where one of the major averages makes a significant rise (currently defined as 1.7% – previously defined as 1%) on increased volume.3) Follow Through Days may occur starting on day 4 of an attempted market rally. Follow Through Days occurring after day 10 are deemed less reliable.4) There has never been a market bottom followed by a bull rally without one.

While at first glance the Follow Through Day seems straightforward, much of it is either vague or inconsistent. IBD says that the concept is backed by decades of research. Unfortunately, to my knowledge, details of this research have never been released to the public. It is difficult to duplicate this research because IBD is vague about important terms – such as what they consider a significant market decline to be and what would determine “success” after a Follow Through Day occurs. But just because vague terms and inconsistencies make the research difficult to duplicate doesn’t mean it isn’t worth doing. As you may be beginning to realize, I believe the subject deserves a significant amount of consideration. Rather than try and cover it all at once (and subject everyone to an incredibly long blog entry) I will be doing a series of reports over the next week or two to take an in-depth look at IBD Follow Through Days. In these reports I will attempt to answer such questions as:

1) Are Follow Through Days predictive of a new bull rally?2) Has there ever been a bull rally without one?3) Do they do a good job of picking a bottom (or do they frequently miss too much of the move)?4) Do they work better after small or large market declines?5) Do Follow Through Days occurring more than 10 days after a market bottom yield lower success rates?6) Can I devise a successful trading system using Follow Through Days?

The market put in a strong reversal day last Wednesday. Monday is the first day that a Follow Through Day is possible. Will it provide investors with a quantitative edge? You’re going to find out…

The market finally decided it had endured enough selling and put in a strong afternoon reversal. The bar looks nice on a chart, but is it indicative of a longer-term reversal? To test it I ran the following quantitative study (as usual each trade is $100,000):

Over the first 1-7 days, it appears to be a toss-up, but as you look a little bit further out there appears to be a solid edge to the upside. One reason the edge appears to be lower in the first few days is that the market has just made a large move up. Frequently this initial thrust takes a few days to digest (more on that lower down).

What I find especially compelling about this scenario are the size of the average winners – especially when compared to the average loser. If the reversal bar works, the expectation is for somewhere around a 4-5% follow through in the next 2-4 weeks based on these results. Note the win/loss ratios and profit factors once you get out more than 10 days. They’re quite good.

For a more detailed look I evaluated the results 14 days out. That would put us at the end of the month and the next Fed meeting. Obviously no one will be worried about this backtest when the Fed is about to announce.

Fourteen days out 16 of 24 trades were winners. Of those sixteen winners, all of them pulled back at least 0.5% from the reversal day close at some point. The average drawdown among those 16 winners was 2.6%. The largest drawdown among winning trades was 6.6% which occurred after the reversal bar last August 6th. Five of the sixteen winners actually posted a lower low before turning higher again. In other words, it’s probably not neccessary to chase this trade. There will most likely be some backing and filling which should allow for a better entry point or some scaling in.

I saw several articles and blogs today that suggested strong upside edges were in place. This opposed my findings from last night. Only one of these bothered to show any statistics. When I saw this I decided I had made a mistake in not showing data to go along with my comments. Below are two studies that typified what I was seeing last night.

The first looks at buying the Nasdaq any time it closes lower 8 days in a row and selling X days later.

The second looks at buying the S&P 500 any time the S&P, Dow and Nasdaq all close with an 8-period RSI below 25 and selling X days later.

$100,000 per trade.

I found no compelling evidence for an immediate bounce with these studies. When adding additional trend and breakdown filters as I mentioned last night, the numbers looked even worse.

Perhaps a true washout or a solid reversal could get us the quantifiable edge we seek…

The first 5 days of 2008 have been brutal – and so were the last 3 days of 2007. The Nasdaq has finished lower all 8 days while the S&P 500 and Dow 30 each have had two marginally up days during the period. After all this selling you would think there would be some solid quantifiable edges based on price oscillators.

I ran several tests tonight looking at such things as RSI, Stochastics, percent drops and consecutive lower closes on the major indices. The story was the same whereever I looked. Chances of a bounce within the next 3-5 days weren’t much better than a coin flip. When I took into account the longer term picture of the market and included such factors as the market is trading below its major moving averages or that is has just recently broken below consolidation levels the results looked even worse. In most cases risks outpaced rewards by a fair amount and a coin flip was generous odds.

A bounce may happen any day, but the VXO study I posted the other night laid it out pretty well. Risks remain elevated. My Capitulative Breadth Indicator (CBI) was the one piece of evidence showing a strong edge to the long side. As I noted earlier, that edge has dissipated. Stepping back and waiting for a better edge to appear looks like the right thing to do at this point.

There have been some strong moves up this morning (and yesterday) in stocks that matter to my Capitulative Breadth Indicator(CBI). It will almost certainly close at 3 or lower this afternoon (down from 7). This will signal a fairly quick end to the trade. It is important to understand that the drop in the CBI does NOT indicate the rally attempt will fail. Rather it indicates the capitulative excess has been reduced. The bounce I was looking for arrived. I will be taking profits before the end of the day.

A few years ago I did a study of capitulative action – both among individual stocks as well as indices. From that I devised a system which I have now traded for close to 2.5 years. The most interesting aspect of this system is what I call my Capitulative Breadth Indicator. Without going into much detail the basic indicator looks to measure the breadth of capitulation among a select group of large cap stocks. The idea is that once enough of these stocks meet my criteria, not only they – but the market as a whole, is extremely likely to reverse sharply.

I’ve included a chart below which shows my indicator along with the S&P 500 over the course of 2007:

I generally use two levels to identify extreme capitulative breadth. The first level is a reading of “7” and the second is a reading of “10”. To show the significance of these levels I created a strategy which would buy the S&P whenever my indicator hit a stated level and then exit the trade when it returned to “3” or lower. This can be seen above with the buy and sell markings on the chart.

Below are some basic stats in a table from one of my presentations using different entry levels and “3” or below as the exit:

A few things should be noted:

1) The stats in the table are from 1/1/95 to present. I began trading in 9/2005. The rest is backtested.2) The August action was extremely unusual in the fact that the indicator dropped rather sharply down to “3” on a day when the market also dropped sharply. This was due to a gap up that morning which served to reduce the indicator before the market collapsed. In actuality the August signal was actually good since the trade could have come off in the morning. The “system” results don’t reflect this.3) The tool does an excellent job of alerting me to times when a strong bounce is likely. It only does an ok job of timing that bounce. In other words, the signals may frequently be early. See the November action on the chart for a good example of this. Nicely profitable trades that tested my nerves greatly before the exit came. For this reason I typically like to scale in to these kind of trades.

You’ll notice on the chart that the indicator hit “7” on Friday. This indicates a strong bounce is likely coming (but does not preclude further downside first).

I also use this indicator to look at individual groups and sectors. Based on what I am seeing there, it appears the groups with the best possibility of outperforming on the bounce are 1) Consumer and 2) Technology.

I will continue to update you on significant changes in the Capitulative Breadth Indicator (over 10, at or under 3, etc.).

I’ve posted a lot of stuff tonight. In summation: 1) The VXO is telling me we could bounce at any time, but until we do it’s gonna be ugly. 2) My Capitualtive Breadth Indicator is telling me the bounce should be fairly strong – probably at least strong enough to get back above where we are now. 3) My tiny watch list indicates to me that a strong bounce may not be enough to spark a rally. The upcoming bounce may be playable but don’t hang on too long – there may be further to drop afterwards.

I like to use the VIX (or VXO) as a tool for timing the market. When looking at the VXO I normally relate it to a short-term moving average rather than looking at absolute levels. Below is one test I ran this weekend that I found particularly interesting.

I looked to see what happened if you bought the S&P 500 under the following conditions:

1) The VXO closes at least 10% above its 10-day moving average for 3 days in a row.2) The VXO closes at its highest high in the last 10 days.

In other words, fear has been relatively high over the last 3 days and is now at its highest recent point (if you accept that high option premium is indicative of fear among market participants).

$100,000 per trade. Results below:

At first glance the results seemed to indicate a decent probability of a bounce and profitable system. Closer examination revealed something even more interesting to me. I’ve bolded the last column which shows the size of the average losing trade. When things go wrong – they go REALLY wrong. The average loss was nearly 4.5% in the S&P over the next 6 days!

Next I added a third condition to the test. I wanted to see what happened when the above circumstances occurred while the market was trading below it’s 200 days moving average (as it is now). Again $100,000 per trade. Even scarier Avg Loss column below:

The probability of a bounce is now down to about 50-50 and the average loss is startling. Nearly 6% downside over the next 6 days for the losing trades!

My interpretation: there’s a good chance we could get a bounce here – but if we don’t…watch out!

I use several quantitative techniques for my short-term trades (days), and this blog will primarily focus on short-term quantifiable edges. I also trade using intermediate-term timeframes (weeks). My intermediate-term trading has typically been focused around high-growth momentum plays. Each weekend I run scans to come up with a list of candidates that meet my criteria from a fundamental and momentum standpoint. I then scroll through the list of stocks to try and find stocks that appear to be setting up in basing patterns and whittle the original list down to create my weekly watch list (although many stocks I’ll frequently just carry over from the previous week as well).

When evaluating the market’s health, one area I always look at is leadership. I believe strong leadership can generate a lot of buying enthusiasm. Investors become more interested in the market and rallies can generate significant momentum. People see certain stocks breaking out that quickly making huge gains and they want to find the next one. Momentum begets more momentum in this manner. Therefore, not only do I look at leadership, but POTENTIAL leadership. Potential leadership can many times be found in my watch list – for those are the high growth stocks that are on the verge of completing basing formations. If they succeed in breaking out they may become the next leaders.

When looking at whether a potential rally could have legs, I look at what my watch list is telling me. This week my list is saying to me that picking’s are slim. If we do get a bounce here, there seems to be a good chance it will be little more than that. Stocks are going to need some time to form proper bases before breakouts can build the kind of momentum that will spark investor enthusiasm enough to generate a significant bull move.

Information contained on Quantifiable Edges is provided for education purposes only. Under no circumstances is it to be used or considered as an offer to sell, or a solicitation of any offer to buy securities. While information contained herein is believed to be accurate at the time of publication, we make no representation as to the accuracy or completeness of any data, statistics, studies, or opinions expressed and it should not be relied upon as such. Hanna Capital Management LLC, its employees, owners, and/or affiliates may have positions or other interests in securities (including derivatives) directly or indirectly which are the subject of information shown on Quantifiable Edges. Neither Hanna Capital Management, LLC nor any officer or employee of Hanna Capital Management, LLC accepts any liability whatsoever for any direct or consequential loss arising from any use of this website or its contents. It should not be assumed that the methods, techniques, or indicators presented here will be profitable or that they will not result in losses. Past results are not necessarily indicative of future results. There is a high degree of risk in trading. Hypothetical or simulated performance results have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, since the trades have not actually been executed, the results may have under- or over-compensated for the impact, if any, of certain market factors such as lack of liquidity. Simulated trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown.